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Fixed-Income Insights

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Emerging Market Corporate Bonds: An Investment-Grade Opportunity

February 27, 2014

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Emerging market corporate debt is fast becoming an asset class that is difficult to ignore. Companies in the emerging markets are likely to account for 40–50% of the Fortune Global 500 by 2025, twice today’s share.

Emerging market (EM) corporate debt is by no means a new asset class. Many companies in emerging markets already have a long history of bond issuance—in some cases, stretching back more than 30 years. And Lord Abbett has been an active participant in the EM corporate bond sector for nearly two decades, with holdings spread among half a dozen fixed-income funds.

But by and large, U.S. investors are not taking advantage of the potential growth opportunity that exists in this market, with relatively small portfolio allocations. This is surprising when one considers the fact that the asset class:

is predominately investment grade;

typically offers yields higher than investment-grade U.S. government bonds; and

historically has had a low correlation to U.S. corporate bonds, thus providing portfolio diversification benefits as well.

In addition to regional and niche players, emerging markets are home to many strong global enterprises, some of which are world leaders in their respective industries. Emerging market companies are becoming more competitive in the global economy, often acquiring firms in developed nations. Record-low borrowing costs, as well as investment and refinancing needs, are fueling the expansion of the EM corporate bond universe. And as banks have continued to scale back term lending in the face of capital-adequacy tests, more and more EM companies have been tapping the capital markets.

According to the McKinsey Global Institute (MGI), the research arm of the consultancy McKinsey & Co., companies in the emerging markets are likely to account for 40–50% of the Fortune Global 500 by 2025, twice today's share and up from just 5% during the period 1980–2000.1

In short, EM corporate debt is fast becoming an asset class that is difficult to ignore. Our experience in this market has convinced us of the potential for future growth in this space, and we believe that active management, applying the knowledge of experienced credit and risk analysts, can best capitalize on the opportunities there.

Let's begin with a brief overview of the EM corporate bond asset class, in terms of its composition, market size, and geographic diversity.

Defining the Asset Class
Today, the EM corporate bond market is approaching $2.6 trillion in size, according to J.P. Morgan. That number includes debt issued in local currencies and debt issued in foreign or so-called hard currencies, such as the U.S. dollar or euro. In terms of accessibility to investors, there is a big difference between the two.

The local-currency EM corporate bond markets are generally characterized by small-sized debt issues, unfavorable withholding tax treatment, poor custody arrangements, legal restrictions, and capital controls. As EM sovereign balance sheets continue to improve and as domestic capital markets deepen, we expect some of these barriers will be eased or even eliminated. But for the foreseeable future, the local-currency debt market offers limited opportunity for overseas investors.

The U.S. dollar-denominated sector is the largest currency bloc in the hard-currency market; EM U.S. dollar corporate bonds outstanding, for the first time, exceeded $1 trillion in 2012, and issuance far exceeds that of dollar-denominated EM sovereign bonds. (See charts 1 and 2.) In fact, as markets have developed, sovereign borrowing has shifted to local-currency debt. Corporate debt today accounts for roughly 80% of EM external debt issuance, J.P. Morgan has reported.

Chart 1. The EM Corporate Market Exceeded $1 Trillion for the First Time in 2012

Total size of the EM corporate bond market

Source: J.P. Morgan. As of September 2013.

Chart 2. External Debt Issuance Has Shifted to Corporates

Annual issuance

Source: J.P. Morgan. As of June 2013.

The asset class now rivals the size of the U.S. high-yield corporate bond market.2 The U.S. dollar-denominated EM corporate universe is not only large and growing but also broadly diversified, both in terms of geography and industry. As of November 27, 2013, the J.P. Morgan Corporate Emerging Market Bond Index Broad Diversified (CEMBI-BD),3 the common benchmark for corporate strategies, represented 1,017 separate bond issues from 482 issuers in 42 countries and across 12 broadly defined industry sectors. (See Chart 3 and Table 1.)

Source: J.P. Morgan. Data as of November 30, 2013.Performance quoted represents past performance. Past performance is not a guarantee or a reliable indicator of future results. The historical data shown in the chart are for illustrative purposes only and do not represent any Lord Abbett mutual fund or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

Source: J.P. Morgan. *Technology, Media & Telecommunications.
The average yield is the market-value-weighted average yield to maturity of a portfolio of bonds. Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates.

The Investment Opportunity
Emerging nations are fundamentally stronger than they were 10 years ago, thanks to improved macroeconomic policies and debt management practices. As a result, they have assumed increased significance in the global economy, representing 36% of global gross domestic product (GDP) in the second quarter of 2013, up from only about 20% 10 years ago. By 2025, nearly half of total global consumption is expected to come from emerging markets. J.P. Morgan anticipates 4.6% GDP growth in emerging markets for 2013, compared with 1% GDP growth in developed markets.4 Longer term, Lord Abbett expects industrialization, urbanization, and a growing middle-income class to continue to fuel growth in these markets.

Economies that had once been more traditionally focused on rapid industrialization by developing the oil and gas, basic materials, and metals and mining sectors will likely continue to evolve by further developing industries such as telecommunications, banking, homebuilding, and water and electrical utilities needed to provide for millions of new city dwellers.

Emerging market corporate bonds allow investors to tap into the next stage of EM economic growth and development by investing in the debt of corporations that appear best positioned to take advantage of positive secular trends.

Historically, U.S. dollar-denominated sovereign debt (i.e., debt issued or guaranteed by EM governments) has been the main focus for investors. But we believe that the largest opportunities for potential excess return currently exist not in government bonds but in the debt issued by EM companies, specifically bonds denominated in U.S. dollars.

As the EM corporate debt asset class has matured, a combination of competitive yield and increasingly strong fundamentals has contributed to attractive double-digit average returns with relatively low volatility. For the period January 2009 through November 2013, for example, the CEMBI-BD earned a Sharpe ratio5 comparable to other major fixed-income asset classes. (See Table 2.) Although there is no guarantee of future results, this volatility-adjusted performance measure has, historically, signified attractive return per unit of risk, particularly given EM corporates' investment-grade bias.

Performance statistics by asset class: trailing five years risk/reward, December 2008–November 2013

Source: J.P. Morgan, Barclays, BofA Merrill Lynch, Morgan Stanley, and Standard & Poor's.Performance quoted represents past performance. Past performance is not a guarantee or a reliable indicator of future results. The historical data shown in the chart are for illustrative purposes only and do not represent any Lord Abbett mutual fund or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
The Sharpe ratio is a measure of risk-adjusted performance. It is calculated by subtracting the risk-free rate—such as that of the 10-year U.S. Treasury bond—from the rate of return for a portfolio and dividing the result by the standard deviation of the portfolio returns. The greater a portfolio’s Sharpe ra tio, the better its risk-adjusted performance has been.Standard deviation is a measure of the dispersion of a set of data from its mean. The more spread apart the data, the higher the deviation.

Over the past few years, EM debt issuers, both corporate and sovereign, took advantage of low interest rates to refinance older, more expensive debt, term out shorter-tenor debt, execute business plans, and expand balance sheets, while also improving financial flexibility. As a consequence, the breadth and diversity of the market has expanded, increasing the investment attractiveness of the asset class.

In 2012, corporate and sovereign debt sales in emerging markets hit $411 billion, more than 80% of which was issued by the corporate market, according to J.P. Morgan (see chart 2). This continues a growth trend that has been visible over the past six years, with corporate bond issuance, including issues from state-owned companies, nearly three times the level of sovereign bond issuance.6 According to Bloomberg, 183 EM companies were first-time bond issuers in the global capital markets in 2013.

As EM corporate bonds are added to more indexes, the broad reach of these global bond indexes allows EM debtors the capacity to offer larger issuance sizes along multiple tranches. During 2012, for example, the typical benchmark size issue for EM corporates was $500 million to $1.0 billion, well within the range of developed-country benchmark-sized issues.7

Notable in 2013 were multibillion-dollar deals. Among the top 30 were issues from Petrobras (Brazil), PEMEX (Mexico), Ecopetrol (Columbia), Gazprom and Lukoil (both of Russia), Kazmunaigaz (Kazakhstan), Saudi Electric (Saudi Arabia), CNOOC and Sinopec (both of China), Pertamina (Indonesia), and AngloGold (South Africa).8 Russia's Lukoil, which is rated 'Baa2'/'BBB' by Moody's and Standard & Poor's, raised $3 billion in an offer in September that was three times oversubscribed.9

Clearly, EM corporate debt is no longer a fringe asset class, but a mainstream part of the market with substantial issuance, market access, and the ability to do large transactions.

Attributes of the MarketLiquidity—With volume and tradable issuance size up, liquidity across the EM corporate credit sector has improved dramatically. The market is also characterized by a vibrant and increasingly liquid secondary market. According to the Emerging Market Traders Association (a trade forum for EM investors and dealers), trading in EM corporate debt set a new high-water mark in calendar year 2010 on a U.S. dollar basis and has generally continued at a robust pace ever since. With record-setting secondary market trading turnover of more than $800 billion in that year, corporate debt continues to constitute an increasingly higher percentage of the overall secondary market trading volume for all EM external debt.10

Investment-grade credit quality—According to J.P. Morgan, the EM corporate debt market is largely an investment-grade asset class, with 70% of corporate debt stock rated 'BBB-' or above, as of September 30, 2013. Just a decade ago, the portion of the asset class considered investment grade was less than 40%.

Low leverage—One of the key attractions of the asset class is that EM companies are currently, on average, less leveraged than their U.S. counterparts, across the credit spectrum. The lower leverage not only reflects a more conservative style of management at EM companies but also stems partly from the previous unavailability of international funding markets for some emerging market firms.

Low default rates—Historically, the lower leverage of EM companies has led to lower default rates relative to comparably rated U.S. firms. According to Standard & Poor’s, using data between 1986 through March 2013, the default rates of high-yield U.S. firms have been higher than in emerging markets two-thirds of the time over the past 12 years. Currently, there are indications that EM corporate default rates may be on the rise again. For investors, this should be a clear reminder of the need for accessing the professional credit and risk analysis skills of active managers when pursuing opportunities in this space.

High yields—Despite the investment-grade ratings, lower historical default rates, and lower leverage relative to U.S. firms, the EM bond market retains a broad reputation as a high-yield debt substitute. So EM corporate bonds historically have tended to have higher yields than their comparably rated counterparts in developed markets. For a fundamental, active EM debt manager, this may present a long-term opportunity to invest in a higher-yielding name that on a global comparative basis may represent a more sound credit.

Moreover, under credit ratings agency methodology, companies generally cannot be rated above their sovereigns. A company's credit rating, therefore, may not be an accurate reflection of its underlying business fundamentals. However, when a sovereign is upgraded, many firms with constrained ratings automatically follow suit and enjoy meaningful price appreciation—particularly when the home country earns investment-grade status. Thus, the additional yield in the EM corporate sector can be considered compensation for factors such as sovereign risk, not necessarily the credit risk of the firm.

In recent years, the improving creditworthiness of EM sovereigns has made an investment in EM corporate debt primarily a source of credit diversification with the potential to enhance returns. As investors become more familiar and comfortable with the issuers in EM corporate debt, we expect this yield premium to reduce, and we anticipate that returns will better reflect the business fundamentals of these firms.

Investor Demand
Heavy EM corporate issuance over the past couple of years has been met with increasing investor demand as higher relative yields, improving corporate fundamentals, and ever-improving liquidity have attracted a global investor base. Traditional EM investors are expanding their former sovereign-dominated mandates. And as EM corporate bonds meet the requirements for inclusion in EM corporate bond benchmarks, global investment-grade buyers are also becoming interested in the asset class.

But the largest participants in the EM corporate debt market thus far have been the institutional investors, such as EM sovereign wealth funds, insurance companies, and pension funds. J.P. Morgan reports that between 2005 and 2011, pension fund and insurance company assets invested in EM regions doubled, reaching a combined $4.3 trillion.11 The ongoing inflow of funds from sophisticated investors is supporting the asset class, helping to reduce volatility.

Still, while adoption of the asset class has grown in recent years, EM corporate bonds remain underinvested relative to other EM and developed-market fixed-income sectors, despite the relatively large size of the market. Dedicated exposures to EM corporate bonds are still in their infancy among fund structures. While J.P. Morgan reported a 60% increase in assets tied to its CEMBI family of indexes over calendar-year 2012, the level of assets is still only at $47.5 billion, less than 8% of the EM corporate bond investable universe.12

Asset-Class Risks
While we like the current risk/return profile of EM corporates, analysis of corporate issuers must start with the sovereign. Examining a country’s financial picture and governance practices is a critical component of credit research. So questions need to be asked, such as: Is there respect for the rule of law? How are creditors treated? How are bankruptcies resolved?

At the company level, capital structure and subordination risk are also important considerations for the investor. Priority access to cash flow is crucial in determining default and recovery scenarios, which in turn drives the relative valuation of a bond. It comes down to the exact position of the debt within the company structure, which can often be more complicated to discern in EM companies. Companies often built up various subsidiaries for tax and legal planning purposes. It is important to know the entity from which the bonds are issued and the seniority of the bond, and map that to how cash flows between different entities of the same company. And in some firms, accounting standards and corporate governance in EM firms still lag those of developed economies.

Outlook
The number of emerging market companies is likely to surge over the next few decades, and as they grow, they will become competitors with, but also customers for, developed-country firms. Almost three-quarters of today's 8,000 companies with annual revenue of $1 billion or more are based in advanced economies. MGI projects that by 2025 another 7,000 will have joined their ranks, with seven out of 10 of them based in emerging markets.13

This projected trend likely will shift more of the world's decision making, capital, standard setting, and innovation to emerging markets and, we believe, should open up vast investment opportunities. We believe investors would be wise to consider emerging market corporate bonds as part of a diversified portfolio.

Source: BofA Merrill Lynch Global Research, June 30, 2013. Leverage ratio refers to debt to EBITDA.
U.S. high yield is represented by the BofA/ML High Yield Master Index. The index is a commonly used benchmark for high-yield corporate bonds and is an unmanaged index composed of publicly placed, nonconvertible, coupon-bearing domestic debt. Issues in the index are less than investment grade as rated by Standard & Poor's or Moody's, and must not be in default. Issues have a term to maturity of at least one year. EM high yield is represented by the BofA/ML Emerging Markets Corporate Plus Index. The index contains only U.S. dollar-denominated EM corporate bonds that meet minimum size requirements. The index also limits exposure to individual countries and issuers.

Chart 6. Historically, EM Corporate Debt Has Offered Higher Yields Than Its Counterparts in Developed Nations

Average yield by credit rating

Source: BofA Merrill Lynch and J.P. Morgan. U.S. corporates are represented by the BofA/ML U.S. Corporate Master Index (yields broken out by credit quality), which is a market-value weighted index that tracks the performance of U.S. dollar-denominated investment-grade rated corporate debt publicly issued in the U.S. domestic market. To qualify for inclusion in the index, securities must have an investment-grade rating (based on an average of Moody's, S&P, and Fitch) and an investment-grade-rated country of risk (based on an average of Moody's, S&P, and Fitch foreign currency long-term sovereign debt ratings). Each security must have greater than one year of remaining maturity, a fixed coupon schedule, and a minimum amount outstanding of $250 million. EM corporates as represented by the J.P. Morgan CEMBI Broad Diversified Index (yields broken out by credit quality). As of October 31, 2013.Performance quoted represents past performance. Past performance is not a guarantee or a reliable indicator of future results. The historical data shown in the chart are for illustrative purposes only and do not represent any Lord Abbett mutual fund or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
Average yield to worst is the lowest potential yield that can be received on a bond without the issuer defaulting.

1 "Urban World: The Shifting Global Business Landscape," McKinsey Global Institute, October 2013.2 "Emerging Markets Corporate Debt: A Bright Spot in the Bond Market," Fischer Francis Trees & Watts UK Limited, July 2013.3 The JPM CEMBI BD is a market capitalization-weighted index that tracks total returns of U.S. dollar-denominated debt instruments issued by corporate entities in emerging market countries. The index limits the current face-amount allocations of the bonds in the CEMBI Broad by constraining the total face amount outstanding for countries with larger debt stocks.4 BofA Merrill Lynch Macroeconomic Data and Forecasts, August 2, 2013.5 The Sharpe ratio is a way of measuring the historical risk-adjusted return on an investment. It is the average previous return minus the risk-free return, divided by the standard deviation (a measure of risk that looks at the diversion of actual returns from expected returns). The higher the Sharpe ratio, the better the returns have been relative to risk.6 J.P. Morgan, January 20137 "Emerging Markets Corporate Bonds: Seizing Opportunities in the 21st Century," Western Asset Management Company, March 2013.8 Bloomberg.9 Chris Wright, "Corporate Bond Issuance Set to Boom," Emerging Markets.org, October 5, 2013.10 Emerging Market Traders Association, June 30, 2012.11 Joyce Chang, Tejal Ray, and Camryn Collins, "EM Fixed Income Rerates as an Asset Class," J.P. Morgan, September 2012.12 "Emerging Markets Corporate Bonds: Seizing Opportunities in the 21st Century," op. cit.13 "Urban World: The Shifting Global Business Landscape," op. cit.

Risks to Consider: Foreign investments generally pose greater risks than domestic investments, including greater price fluctuations and higher transaction costs. Special risks are inherent in international investing, including those related to currency fluctuations and foreign, political, and economic events. The securities markets of emerging countries tend to be less liquid, to be especially subject to greater price volatility, to have a smaller market capitalization, and to have less government regulation and may not be subject to as extensive and frequent accounting, financial, and other reporting requirements as securities markets in more developed countries. Further, investing in the securities of issuers located in certain emerging countries may present a greater risk of loss resulting from problems in security registration and custody or substantial economic or political disruptions. Foreign curre